## Info

^ eqmult.xls: This spreadsheet allows you to estimate the equity multiples for a firm, given its fundamentals.

^ firmmultxls: This spreadsheet allows you to estimate the firm value multiples for a firm, given its fundamentals.

The Use of Comparable Firms

### The Use of Comparable Firms

When we use multiples, we tend to use them in conjunction with "comparable" firms to determine the value of a firm or its equity. This analysis begins with two choices - the multiple that will be used in the analysis and the group of firms that will comprise the comparable firms. The multiple is computed for each of the comparable firms, and the average is computed. To evaluate an individual firm, we then compare its multiple to the average computed; if it is significantly different, we make a subjective judgment about whether the firm's individual characteristics (growth, risk or cash flows) may explain the difference. Thus, a firm may have a PE ratio of 22 in a sector where the average PE is only 15, but the analyst may conclude that this difference can be justified because the firm has higher growth potential than the average firm in the industry. If, in the analysts' judgment, the difference on the multiple cannot be explained by the variables listed in Table 12.7, the firm will be viewed as over valued (if its multiple is higher than the average) or undervalued (if its multiple is lower than the average). Choosing comparable firms, and adequately controlling for differences across these comparable firms, then become critical steps in this process. In this section, we will consider both these decisions.

### 1. Choosing Comparables

The first step in relative valuation is usually the selection of comparable firms. A comparable firm is one with cash flows, growth potential, and risk similar to the firm being valued. It would be ideal if we could value a firm by looking at how an exactly identical firm - in terms of risk, growth and cash flows - is priced. In most analyses, however, analysts define comparable firms to be other firms in the firm's business or businesses. If there are enough firms in the industry to allow for it, this list is pruned further using other criteria; for instance, only firms of similar size may be considered. The implicit assumption being made here is that firms in the same sector have similar risk, growth, and cash flow profiles and therefore can be compared with much more legitimacy.

This approach becomes more difficult to apply when there are relatively few firms in a sector. In most markets outside the United States, the number of publicly traded firms in a particular sector, especially if it is defined narrowly, is small. It is also difficult to find comparable firms if differences in risk, growth and cash flow profiles across firms within a sector are large. Thus, there may be hundreds of computer software companies listed in the United States, but the differences across these firms are also large. The tradeoff is therefore a simple one. Defining a industry more broadly increases the number of comparable firms, but it also results in a more diverse group.

### 2. Controlling for Differences across Firms

In Table 12.7, we listed the variables that determined each multiple. Since it is impossible to find firms identical to the one being valued, we have to find ways of controlling for differences across firms on these variables. The process of controlling for the variables can range from very simple approaches, which modify the multiples to take into account differences on one key variable, to more complex approaches that allow for differences on more than one variable.

Let us start with the simple approaches. In this case, we modify the multiple to take into account the most important variable determining it. Thus, the PE ratio is divided by the expected growth rate in EPS for a company to determine a growth-adjusted PE ratio or the PEG ratio. Similarly, the PBV ratio is divided by the ROE to find a Value Ratio, and the price sales ratio is divided by the net margin. These modified ratios are then compared across companies in a sector. The implicit assumption we make is that these firms are comparable on all the other measures of value, besides the one being controlled for.

Illustration 12.14: Comparing PE ratios and growth rates across firms: Entertainment companies

To value Disney, we look at the PE ratios and expected growth rates in EPS over the next 5 years, based on consensus estimates from analysts, for all entertainment companies where data is available on PE ratios and analyst estimates of expected growth in earnings over the next 5 years. Table 12.8 lists the firms and PE ratios.

Table 12.8: Entertainment firms - PE Ratios and Growth Rates - 2004

Company Name

Ticker Symbol

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